How Banks Value Commercial Property

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This is a bit of a misnomer because in truth its Valuers that perform this role in most cases not banks.   This is not meant to be a lesson in valuation by the way, apparently I need a degree to perform that job, so for now its just information based on my experience in the business that you are getting.

Valuers use a number of methods to determine a range of values for a commercial property and then usually select the most appropriate method or a price within the computed range.

Method 1 – Capitalisation Rates

This method uses the rental income of properties combined with a Capitalised Rate or Capped Rate to work out a value.   It is usually determined by what is happening in the market overall, the local market, the nature of the leases in place and any extra ordinary expenses a landlord may have to pay.

Let’s say that the net income from the property produces a return on your property of $100,000 per annum.   Let’s also assume that the valuers and banks know that people buying commercial property right now want a return of 8.5%.   To work out the value of the property they would use the following calculation:    $100,000 divided by 0.085 = $1.176M.    Now, to check if the number is correct of course you can just take $1.176 x 8.5% = $99,960.  It has to work really doesn’t it!!!

Now, this number of $1.176M is usually compared to what is being paid for in the area by comparing recent sales.

 

Method 2 – Recent Sales

Valuers will search the local area for similar properties and their sales prices and then compare them to the property you are buying.   They will then list these in the report and describe them.   Usually they find a few that are of better quality than yours and some that are lesser quality to justify the pricing.

 

In many cases valuers will use the above methods together to produce a result.

So, they know that the rate people are willing to pay for a property produces a return of 8.5%.   They have also found a number of properties in the area you wish to buy in with rents of $100,000 that have been sold at between $980,000 and $1.3M.   These two pieces of information can then be used to justify the valuation of say $1.2M

The problems usually occur between borrowers and banks when someone owns a commercial property themselves and wants to borrow more money when the market is in a downturn.   In this situation, you may own a property and have no intention of selling.  You might have a great tenant and a great business so your risk profile is low.   Unfortunately because the properties around you are being sold for cheap prices as people default on their loans, your own property value comes down.   This not only affects your current borrowing capacity but may affect your banking facilities.

Imagine if your overdraft or term loan is expiring and you want to extend it, only to find that the collateral you have with the bank just dropped in value by 30%?    It happens, regularly!!!

 

 

 

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